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Resident Capital Outflows: Capital Flight Or Normal Flows? a Statistical

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Resident Capital Outflows: Capital Flight Or Normal Flows? a Statistical Working Paper 195 Resident Capital Outflows: Capital Flight or Normal Flows? A Statistical Interpretation Benu Schneider March 2003 Overseas Development Institute 111 Westminster Bridge Road London SE1 7JD UK Acknowledgements This paper is the second part of a project on Capital Flight from Developing Countries. The project is funded by ESCOR, Department for International Development, UK and we gratefully acknowledge their financial support. The UK Department for International Development (DFID) supports policies, programmes and projects to promote international development. DFID provided funds for this study as part of that objective but the views and opinions expressed are those of the author alone. The author would also like to thank Dr. Habil. Uwe Jensen, University of Kiel for comments. ISBN 0 85003 634 8 © Overseas Development Institute 2002 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the publishers. ii Contents Acknowledgements ii 1 Introduction 1 2 Trends in Resident Capital Flows 3 3 Explanations for Resident Capital Outflows 6 3.1 Investment climate 6 3.2 Asymmetric information and risk 8 3.3 Economic and political instability 8 4 Analysis Technique and the Results 10 4.1 Number of factors 14 4.2 Factor analysis options 14 4.3 Regional factor analysis results 15 4.4 Interpretation of the results 16 4.5 Results of factor analysis for selected countries 18 4.6 Factor analysis results 19 4.7 Interpretation of the results 19 5 Conclusion: Implications of the Findings 24 References 26 Appendix 1 Country groups 29 Appendix 2 Scree plot by country 30 Appendix 3 Data used for regional analysis 32 Appendix 4 Correlation between components of capital flows by region, 1982–98 35 Appendix 5 Correlation between components of capital flows by country, 1982–98 36 iii Figures, charts and tables Figures Figure 1 Regional estimates of capital outflows 4 Figure 2 Estimated resident capital outflows as a ratio to GDP – by region 5 Charts Chart 1 Model adopted for analysis 11 Chart 2 Scree plots by region 13 Chart 3 Resident capital outflows: regional and individual country measure of uniqueness 19 Tables Table 1 Kaiser-Meyer-Olkin measure of sampling adequacy (MSA) for regional analysis 12 Table 2 Principal components of capital flows: commonality, factor loading and cumulated percentage of explained variation (CPV) 14 Table 3 Results of factor analysis for the six regions 17 Table 4 Kaiser-Meyer-Olkin measure of sampling adequacy (MSA) for selected countries 18 Table 5 Results of factor analysis for selected countries 20 iv 1 1 Introduction Access to finance by developing countries is a matter of great concern. A related concern is that residents in many capital-scarce countries hold assets abroad which may amount to capital flight. Outflows of resident capital from developing countries have been rising (Schneider, 2001) even when, as in recent years, net capital inflows to them have been falling. It was widely believed in the wake of the debt crisis in Latin America in the early 1980s that resident capital outflows were equivalent to capital flight. The argument was that, had this capital been available domestically, it would have enhanced domestic savings and investment and reduced the reliance on foreign capital.1 Yet in a world where many developing countries have liberalised their capital accounts, and with their subsequent financial integration with the rest of the world, it is extremely difficult to equate them with capital flight. It is therefore important to understand which resident capital outflows occur because of flight motives. One of the purposes of this paper is to illustrate that all resident capital flows cannot be identified as capital flight, and that the response of the international community by merely observing resident capital flows can be overstated.2 Capital flight is defined here as the outflow of resident capital from a country in response to economic and political risk in the domestic economy. The loss of capital through capital flight has implications for the future growth prospects of the country. Capital is already scarce in many of the countries which are believed to experience capital flight and, as a natural corollary, it is assumed that if the funds are held at home they can be utilised to reduce the level of external indebtedness and the inherent liquidity constraints in bridging the foreign-exchange gap. The loss of capital through capital flight also erodes the domestic tax base in developing countries and has adverse implications for the distribution of income. It is feared that the flight of capital from developing countries may send a signal to foreign private investors about the risks involved and lead to a decline in, or even cessation of, private capital flows. The statistical analysis in this paper attempts to provide some demarcation between normal capital flows and capital flight by making an analytical distinction between three sets of explanations for resident capital outflow: • resident capital outflows which occur in response to the investment climate; • resident capital outflows resulting from policies that lead to discriminatory treatment of residents' capital, such as guarantees to, or inflation hedges for, foreign capital. This is a response to asymmetric risk and information that drives a wedge between the actual or perceived risk/return between resident and non-resident capital so that resident capital flow is one side of a two-way flow; • resident capital outflows as a response to economic and political instability. The paper attempts to classify resident capital outflows as either normal flows or capital flight. The hypothesis is that estimates of resident capital outflows may be measuring perfectly normal flows. If known normal flows (inflows of external debt, net foreign direct investment, bond and equity flows) and resident capital flows can be explained by common explanatory factor(s), this would indicate that the outflow is normal. The paper then studies the relationship between resident capital flows and identified normal inflows of capital to interpret the nature of resident capital flows across regions and a selected sample of countries. 1 In the 1980s this argument did not go undisputed. Yet, almost all empirical research on capital flight since the debt crisis in the early 1980s equates resident capital outflows to capital flight for all developing countries. 2 Some examples of this response include US Treasury Secretary James Baker's comment in 1985: 'It is unrealistic to call upon the support of voluntary lending from abroad, whether public or private, when domestic funds are moving in the other direction'. Commercial bankers also voice similar sentiments and describe themselves as 'understandably reluctant to provide fresh funds unless the debtors put a stop to capital flight' (De Vries, 1986, p.6). 2 If the explanatory power of the common factor(s) is low and the uniqueness of resident capital flows is high, the result would be indicative of capital flight. If high uniqueness (capital flight) is accompanied by common factor(s), then some part of the flow may be normal resident flows. If the same signs are obtained for the common factor(s) for all types of flows, it is indicative that resident capital flows are financing some inflow of capital or vice versa. If the sign for the resident capital flow is negative, it is indicative that an improvement in the common factor (investment climate) is leading to inflows of resident capital. The former can be described as round tripping,3 although the direction of causality cannot be established from the analysis. The latter would be the most acceptable case for a normal flow. This paper therefore examines the relationships among all types of capital flows and in particular that between resident capital flows (RKF) and other components. The relationship between resident capital flows was examined in earlier studies with two specific questions in mind: • Does external debt finance capital flight?4 • Does FDI finance capital flight? Another category is now added: • Does resident capital outflow finance an inflow? Thus resident capital flows can be one side of a two-way flow response to asymmetric risk. The method used in this paper is a departure from earlier studies. While Kant (1996) examined the extent of co-movement between capital flight, portfolio flows and FDI using principal component analysis, more information can be gauged by using factor analysis. Kant (1996) interpreted the first principal component as investment climate and it took all the variance of the data set into account, thus ruling out any uniqueness for capital flight. This is probably because his analysis does not allow for the possibility that his estimates of capital flight may contain a normal component and an abnormal component, and instead features all resident outflow as capital flight. This paper takes the analysis further by using factor analysis to split the total variance explainable by the model into common variance (due to normal flows) and variance that is unique. The paper is organised along the following lines. The next section presents trends in resident capital flows. Estimates of resident capital flows are from Schneider (2001). Section III discusses the conceptual differences between resident capital flow as a one-way flow in response to the investment climate, resident capital outflows as one side of a two-way transaction and also resident outflows as a result of abnormal risks. This provides the basic rationale for the statistical exercise. Section IV describes the techniques adopted for the analysis and presents the results. The concluding section considers the main implications emerging from this analysis. 3 Dooley (1988) explained round tripping as due to asymmetric risk and asymmetric information.
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